The Legal Trump Card: Make Them Produce the Note
A basic principle of contract law is that a plaintiff suing on a written contract must produce the signed contract proving he is entitled to relief. If there is no signed mortgage note or recorded assignment, foreclosure is barred. The defendant must normally raise this defense, and most defaulting homeowners, unaware of legal procedure and concerned about the expense of hiring an attorney, just let their homes go uncontested. But when the plaintiffs bringing subprime foreclosure actions have been challenged, in most cases they haven’t been able to produce the notes.
Why not? It appears to be more than just sloppy paperwork. The banks that originally entered into these risky subprime arrangements generally did so because they had no intention of holding the loans on their books. The mortgages were immediately sliced and diced, bundled up as mortgage-backed securities (MBS), and sold off to investors. Loan originators sold the mortgages to financial institutions or other banks, which then sold the rights to the monthly mortgage payment income to investors, while transferring the responsibility to collect these payments to specialized mortgage servicing companies. The result has been to slice up the mortgage contract, with no party really having ownership of the original paperwork. When foreclosure has been initiated, the servicer or trustee acting as plaintiff now has trouble proving that it originated the mortgage or owned the loan. In order for a second bank or financial institution to have standing to bring a foreclosure lawsuit in court, it must have been assigned the mortgage; and with the collapse of the housing market, many of the subprime lenders have gone out of business, making it impossible to contact the originating mortgage company. Other paperwork has just been lost in the shuffle.2
Why weren’t the mortgage notes assigned to the MBS holders when they were first sold? Apparently because the investors aren’t even matched up with specific properties until after default. Here is how the MBS scheme works: when the mortgages are first bundled by the banks, all of the subprime mortgages go into the same pool. The bundled mortgages are chopped into "securities" that are sold to many investors -- banks, hedge funds, money market funds, pension funds -- with different "tranches" or levels of risk. The first mortgages to default are then assigned to the high-risk "BBB-" tranche of investors. As defaults increase, later defaulting mortgages are assigned down the chain of risk to the supposedly more secure tranches.3 That means the investors get the mortgages only after the defendants breached the agreement to pay.
It also means the investors weren’t a party to the agreement when it was breached, making it hard to prove they were injured by the breach.
The investors have another problem: the delay in assigning particular mortgages to particular investors means there was no "true sale" of the security (the home) at the time of securitization. A true sale of the collateral is a legal requirement for forming a valid security (a secured interest in the property as opposed to simply a debt obligation backed by collateral). As a result, the investors may have trouble proving they have any interest in the property, secured or unsecured.4